Market Trends

Fleets Reassess Amortization Rates

In the commercial fleet industry, the most common amortization rate used for establishing a depreciation reserve is 50 months. At this rate, the original value of a vehicle is reduced to zero over the 50-month term. Each month, 2 percent of the capitalized cost is placed into a reserve for depreciation. This practice is known as establishing a reserve for depreciation, and its goal is to reduce the original value of the vehicle on the company's books so its unamortized book value will approximate its resale proceeds.

Recently, some major fleets extended amortization rates on new-vehicle orders. A lower depreciation rate decreases monthly lease payments. Changing to a 60-month amortization reduces the percentage placed in depreciation reserve to 1.67 percent. One reason for the change is the anticipation of higher residual values over the next several years, which will offset a lower depreciation reserve. If a sustained period of strong resale values occurs, more fleets are expected to move to longer amortization periods. "Fleet managers want to be sure the upswing in the used-vehicle cycle will be sustained. We are starting to review amortization rates for some of our clients' future orders," said Greg Corrigan, VP, strategic consulting for PHH Arval.

Determining Depreciation Rates

When determining depreciation, the lessee and lessor agree on the rate the original cost (capitalized cost) of the vehicle is reduced, or amortized. In theory, this is the rate at which the actual (market) value will decline over time, so that at the point the vehicle is sold, the remaining value matches the vehicle's actual value on the open market. In effect, a portion of each lease payment is set aside - "reserved" - to cover the depreciation that occurs as the vehicle ages and mileage accumulates.

In the real world, this process is more complex and other factors come into play. For instance, when vehicles are funded under a TRAC lease, the rate of depreciation is sometimes calculated by a lessor to make the monthly lease payment market-competitive. This sometimes results in deficiencies at end of a vehicle's service life. Other times, to protect against large deficiencies on resale, amortization rates are set higher than necessary, resulting in resale proceeds higher than book value.

Some fleet managers like this approach as it makes them look good when high resale revenues are generated. However, avoid "over-amortization." This practice unnecessarily ties up corporate capital that could be used for other income-producing purposes.

"The recommended amortization is to achieve a small gain on sale to break even, such as a plus or minus $500 residual gain or loss. This is ideal. This is a virtual break-even," said Corrigan.

Anticipation of Strong Residuals

In 2009, commercial fleet sales decreased 39.8 percent. Not only were fewer fleet vehicles sold, but there was a corresponding decrease in retail sales and trade-ins. If the new-vehicle market generates the used vehicles of tomorrow, there will be fewer used vehicles in the future. If new-vehicle sales decrease over a multiyear period, there will be a corresponding decrease in the future availability of used vehicles in the wholesale market.

There is a lag time in the "used-vehicle manufacturing" process. For instance, 2009 fleet models will not enter the wholesale used-vehicle market until 2011 or 2012. In addition, the economy functions in business cycles, and eventually, there will be a cyclical upswing. When this occurs, there will be a tighter supply of used vehicles, especially trucks, due to the pent-up needs of the construction industry, which is deferring the purchase of replacement vehicles. A smaller supply of used vehicles means demand will exceed supply, especially in a rebounding economy. This creates a "rising tide" effect of stronger demand for all used vehicles, resulting in higher resale prices. "Historically, when emerging from recessions, the used-vehicle market always led the way. We are likely to see short- and longer-term strength in the used-vehicle market for those reasons," said Corrigan.

Potential Risks and Rewards

However, modifying amortization rates presents risks. You can't predict the future with absolute certainty, and if the used-vehicle market does not stay at today's strong level, lessees will be setting themselves up for a potential loss on resale.

"Another wildcard is if improved resale values are met with higher up-front costs for vehicles, which over time will negate each other from a depreciation standpoint. In this case, I'm not sure amortization rates should be adjusted," said Corrigan.

Admittedly, selecting a depreciation rate is a complex process that goes beyond the sole consideration of resale. Nonetheless, resale is a key factor to consider when determining an amortization rate. The relationship between amortization and net depreciation must be carefully analyzed before you can determine most cost-effective amortization rate. A fleet manager's primary focus is determining the most advantageous cash flow and the most effective use of capital for their corporation.

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Comments

1.David Allen[ March 22, 2010 @ 03:45PM ]

Very timely article on depreciation reserve amounts used within the open-end lease product. One key item that wasn't noted though that does play a tangible role in this arena is the credit worthiness of the lessee. Increasing the depreciation reserve from 50 months to 60 increases residual risk to the lessor. In today's economic environment some lessee's may not have the financial strength to support such a move.

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